Tracking Sentiment through Liquidity Pools? – Glassnode’s Latest Research Report

Glassnode has released a new research report titled Tracking Sentiment through Liquidity Pools?

Source: Glassnode

Translation: LianGuaiBitpushNews Tracy

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The digital asset market has once again experienced volatility, with ETH and many tokens experiencing significant declines. The derivatives market indicates that liquidity continues to rise along the risk curve. We also delve into how liquidity pools provide market information.

Executive Summary

• Can DeFi maintain its usability beyond market narrative fluctuations?
• Glassnode Tracking Market Sentiment through Liquidity Pools
• In the context of high inflation and political unrest, Bitcoin has firmly taken root in Africa.

In recent weeks, event-driven volatility has re-entered the digital asset market, and some notable indicators show that total capital outflows are entering the digital asset market.

The derivatives market shows a continuous outflow of liquidity, especially in the Ethereum futures market, indicating that capital continues to move along the risk curve towards relatively safer directions.

We delve into the many similarities between Uniswap liquidity pools and the options market, where liquidity providers express their views on volatility and price levels.

Awakening of the digital asset market

In recent weeks, the digital asset market has awakened from historically mild volatility. This was mainly driven by two key events:

On August 17, in the lightning crash, BTC and ETH fell by 11% and 13% respectively.

On August 29, news broke about Greyscale’s victory in the lawsuit with the U.S. Securities and Exchange Commission (SEC), causing prices to briefly rise, but all gains were retraced in the following three days.

The spot prices of BTC and ETH are currently hovering around the lows of August.

A key indicator tracking the total capital inflow into the industry is the total realized value indicator. This tool combines:

The realized caps of BTC and ETH, the two major cryptocurrencies

The supply of five major stablecoins: USDT, USDC, BUSD, DAI, and TUSD.

It is clear that even before these two major events occurred in early August, the market had entered a state of capital outflow. As of August, approximately $55 billion had left the digital asset space.

This trend was driven by capital outflows from Bitcoin, Ethereum, and stablecoins.

In the Ethereum ecosystem, the indices of the DeFi, GameFi, and Staking industries have varied reactions. Each index is constructed based on the average supply-weighted price of “blue-chip” tokens in that industry.

We can see that compared to the major tokens, DeFi and GameFi tokens have relatively poorer performance (-17%) and (-20%), while Liquid Staking tokens have slightly better performance (-7.7%). However, overall, the downward trend in prices is similar to those in March, April, and June, or not as severe.

Decline in risk appetite in the derivatives market

One of the key developments in the 2021-2023 cycle is the maturity of the derivatives market, especially for Bitcoin and ETH. The way the derivatives market prices these assets can provide information about market sentiment and positions.

The overall activity in the Ethereum futures and options market in 2023 is significantly lower than the levels seen in 2021 and 2022. The daily trading volume in these two markets has dropped to $14.3 billion, about half of the average trading volume in the past two years. This week, the volume is even lower at $8.3 billion, indicating a continued loss of liquidity in this area.

This trend is also reflected in open positions of derivatives. After reaching a low point in the market following the FTX crash, open positions started to climb at the beginning of 2023. In terms of options, open positions reached a peak during the March banking crisis when the price of ETH dropped from $1 to $1. Open interest in Ethereum futures reached its peak before and after the Shanghai upgrade, indicating that this was the last major speculative event for this asset.

Since then, the nominal value of active contracts in both markets has remained relatively stable. Similar to our observation of the Bitcoin market (WoC 32), the current size of the ETH options market ($5.3 billion) is similar to the futures market ($4.2 billion), and in fact, the options market is currently larger.

Since the beginning of this year, the ETH options market has experienced a significant increase, with trading volume growing by 256% and reaching a daily volume of $326 million. At the same time, futures trading volume has steadily declined this year, from a daily volume of $20 billion in early January to only $8 billion today. The only notable exception was during the Shanghai upgrade period, when daily volume briefly rose to around $30 billion.

Given the lack of significant changes in trading volume in both markets in August, it suggests that traders are continuing to move liquidity towards the risk curve.

Looking at the Put/Call ratio, we can see a high response to major news events. For example, after BlackRock applied for a Bitcoin ETF, market sentiment became more bullish and the Put/Call ratio dropped from 0.72 to 0.40.

However, this situation changed after the sell-off on August 17th, with the Put/Call ratio rising to 0.50 and bullish trading volume dropping significantly from $320 million per day to $140 million per day.

Is the liquidity pool the options market?

To support our analysis above, we will now examine the activity of automated market makers (such as the Uniswap ETH/USDC pool). Since the introduction of concentrated liquidity on Uniswap V3, there has been a belief that the liquidity position on Uniswap can be similar to pricing put and call options. While we don’t believe the concept of options fully captures these dynamics, there are certainly many similarities worth further exploration.

Our analysis will focus on the USDC/ETH 0.05% pool, which is the most active Uniswap pool and is expected to provide the highest signal. The 7-day trading volume of this pool is $1.51 billion, with a total value locked (TVL) of $260 million.

Uniswap V3 has unique characteristics of concentrated liquidity. Liquidity providers (LPs) can choose a price range in which their liquidity will concentrate. They only earn fees when the market trades within this range (similar to an execution price), and the narrower the range, the higher the relative fee income. This brings a better user experience to DEX traders as the spreads tend to be tighter and also improves the capital efficiency of limited partners.

In this way, it can be assumed that LP allocation must consider volatility expectations (the spread between upper and lower limits) and expected price range (upper and lower levels). The argument of this article is that assuming LPs actively manage their positions, we may be able to draw similar insights from options market data.

We first observe the overall activity in the USDC/ETH 0.05% pool. For various reasons, we will avoid using TVL as a measure of activity in the pool or the corresponding token pair. Instead, we will express the activity in terms of two metrics:

The daily mint represents the number of liquidity positions opened by LPs, and the daily burn represents the number of liquidity positions closed by LPs.

By these measures, economic activity contracted after the March bank crisis and the April Shanghai upgrade, and then remained at relatively low levels until early June. Then, we saw a surge in new mints and burns around the announcement of the BlackRock ETF, followed by another surge during the sell-off on August 17.

The chart below also shows the net change in LP positions as an indicator of opening and closing balances. We note that this indicator is less affected by market trends but more affected by discrete events, indicating that short-term volatility is a key driving factor.

When examining the distribution of liquidity across different price ranges in the Uniswap pool, we can see that most of the liquidity currently provided by LPs is above the current price.

The most concentrated liquidity (about 30.4% of the capital) is within a 11% price range, with an expected downside buffer of -2.7% and an upside buffer of +8.6%. The second layer of liquidity has a downside buffer of -8.5% and an upside buffer of +23.7%. It can be said that Uniswap LPs express a general optimism about ETH and an expectation of the market going up.

If we compare this with the strike prices of options contracts expiring at the end of September, we can see similar positive prospects. 70% of call options have strike prices between $1,700 and $2,300, while 75% of put options have strike prices between $1,300 and $1,900. These price levels largely align with the liquidity distribution in the Uniswap pool.

Returning to the USDC/ETH Uniswap pool, we can analyze how the concentration of liquidity adjusts over time. The heatmap below shows the density of liquidity, with colors gradually transitioning from cold to hot.

With the expansion of automated LP strategies and execution, liquidity providers have been successful in arranging liquidity very close to spot prices during periods of high volatility. On June 1st, a large amount of liquidity expanded slightly above the prevailing price (indicated by the deeper yellow area). This can be seen as an indication of higher fee income expectations for market makers in that region. This liquidity persisted until the lightning crash in August, when the concentration of liquidity was gradually adjusted to below 1800 US dollars. This chart provides an extraordinary perspective on the extent to which LPs react to market events and volatility.

Equally interesting is the high concentration of liquidity represented by the red area occurring simultaneously with strong price fluctuations and trend reversals. Upon examination, it indeed suggests that the Uniswap liquidity pool can serve as a valuable source of information for measuring market sentiment and positioning.

Summary and Conclusion

The initial optimism surrounding Grayscale’s victory over the U.S. Securities and Exchange Commission was short-lived, as the value of Ethereum quickly fell to its August low within a few days. Cash continued to flow out of the spot market, and liquidity in the derivatives market continued to decline. Overall, investors seemed hesitant to re-enter the market and were more willing to move funds to higher positions on the risk curve.

We conducted research on the Uniswap liquidity pool, attempting to determine whether pricing information similar to the options market could be obtained. Our analysis indicates that liquidity capital is highly responsive to market events and insights can be gleaned from the volatility and price expectations of LPs. Disclaimer: This report does not provide any investment advice. All material is for reference and educational purposes only. No investment decision should be made based on the information provided here, and you must take full responsibility for your investment decisions.

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